Are US Stocks Too Expensive?

September 2023 Newsletter

In my August 2023 Newsletter, I discussed the problem of Market Breadth: too few stocks influencing the entire market. If you thought that was the only problem the market has, you would be wrong. In this Newsletter, I am talking about how expensive US stocks are and why one day we might pay the price for being dumb and not doing something about it.

But is the US market too expensive?

Like all good questions, the answer is “it’s complicated”. US stocks have been frothy many times in the past. We all remember the great tech bubble in 2000 and how that ended. Fear of past financial trauma biases our understanding of markets. Historically high PE ratios have not all ended in bloodshed. It’s somewhat a myth that high PE ratios always end in disaster. Without further context, higher PEs are not very predictive in and of themselves, in the short run or in the long run when so many other things can happen.

We primarily measure how expensive a market is by PE ratios: the Price we pay for each dollar of Earnings. An easy example of this is when we buy a 10$ stock that makes a 1 dollar per share of earnings a year. The PE ratio is 10, or 10$ divided by 1$ – sounds pretty simple. It also means that your theoretical return (earnings yield) is 10%, because if all things remain equal, the stock will keep providing you 1$ a year for that initial investment. PE ratio is not the only factor that determines value; there are many other factors at play such as earnings growth, future expectations, risk, interest rates, and so on. Basically, high or low PE ratios need to be put into economic context to make any sense.

An example of this is when after a recession, earnings falls, creating a high PE ratio. To many, this results in high risk, but when the economy rebounds, it sends earnings and stock prices straight up. So was a high PE risky in this case? No. In this scenario, it was the opposite. For argument’s sake, we will keep it simple and use PE ratios to compare everything against each other…a relativity game. Although High PE ratios are not predictive, they at least give us an understanding of which markets might be cheaper and safer than others at any point in time.

Today the PE ratio of the major indexes are below:

SP500 (SPY): 22
Nasdaq, (QQQ): 29
Russell 2000, (VTWO): 11
MSCI world, (URTH): 19
MSCI europe, (IEUR): 14
Japan 12-15 (sources vary)
TSX 300 (xic): 12.24
Emerging markets, (MSCI, EEM): 11.78

As you can see the US indexes are the most expensive relative to other countries/indexes. Its also expensive relative to its historical averages of around 18 (if I use median figures for SP500).

How did we get here?

Why is the US more expensive compared to Europe or Japan? One could say that the US has out-earned the rest of the world and as such a premium on US stocks is justified. That sounds pretty good, but the reality is that although US stock returns have outperformed over the last 15 years, it’s not the earnings that account for this over-performance. US earnings have only slightly beaten European earnings. Most of the stock over-performance has actually come from PE expansion. Or in other words, US stocks simply got more expensive relative to other indexes.

Is this a problem for the small investor?

Maybe eventually? You could have said this years ago and totally got out of US stocks and well, that would have hurt. You have to remember that 60-70% of the worlds capital markets by weight are US-based. They are a BIG player. You have to have some pretty strong feelings about this to take an anti US stand and get out of US stocks. Even if you are right and US stocks falter, you will still feel the pain (albeit less) as the rest of the world is highly correlated to US capital markets. You could simply go to cash, or bonds, but that rarely works out in the long run either.

There is another similar story that played out if you know your economic history. Japan at one time in the late 80s early 90s, was a relative powerhouse. Historians refer to this as a perfect example of a market bubble. Japan’s stocks could do no wrong and got bid up and up to such heights (PE of 60), that it still has not recovered to this day! There are a lot of reasons that this occurred such as loose monetary policy and general exuberance. Could this happen in the US? Difficult to say, but certainly we could expect that lofty valuations relative to other markets could be a cause for concern. Either foreign markets need to catch up, or US markets need to slow down for an extended period while earnings catch up. Worst case is US markets fall quickly back to normal levels. This is basically a reversion to the mean or in other words, the necessity to get back to normal levels.

Now that you know what I know, what should we do?

I like to adjust the portfolio slowly, after all, this situation has been around for over a decade. It’s not prudent to isolate one’s portfolio completely away from US stocks. In addition, the US market is comprised of many sectors, some of which are not expensive. This is where the small investor can out shine an ETF investor by simply ignoring big expensive companies think Nvidia, Tesla, etc. Historically, being different than the market means being a big winner or a big loser, so you have to be careful. As I said at the beginning, this situation has been around for years, and anyone who was early and shunned US stocks have been a big loser. If markets made sense it would be so easy to buy cheap under valued stock and sell short expensive stock. Guess what, it’s not that simple. No one has ever been able to do this and make reliable money.

Unless you have a crystal ball, you need to continue to be market-like by holding some stocks from the US. You can also choose less expensive (lower PE) US stocks. In addition, foreign stocks in the long run provide similar returns as US stocks, so you can have more foreign exposure with very little performance loss and lessen your risk.

But there is a problem. Even though foreign stocks return similar returns in the long run, US stocks have been leading for the last few years. So if you start increasing your foreign and Canadian positions and the US continues to out-perform, you will likely lag against US markets. You will theoretically average out when the leader position changes. To some people, that is hard to do as no one likes to lag for years.

Another view point that most professionals do not talk about much is the risk related to your return. Even if you underperform a little, yet you have a really safe portfolio by avoiding expensive stocks, you actually could have a superior return when risk is accounted for. In the long run, holding very expensive stock could be disastrous to a portfolio, requiring decades to catch up, if ever. So sometimes being prudent is the better long term approach, even if it costs some performance in the short run.

Moral of the story:

Am I selling all my US positions? No. That would be silly. But understanding that there are markets that are relatively cheaper than US markets, we can adjust our portfolios to take advantage of this. Returns might lag a little at first but in the long run, there is a high probability of over-performance or at the very least a better return for the amount of risk taken.

When constructing or adjusting a portfolio, it’s always good to be diversified by sector, by country, and by type of company. I always like to have a bit of everything including some high flyers as well as some of the most boring of companies. This month, in light of the theme of this newsletter, I sold Honeywell (HP) with a PE of 24 and replaced it with Mitsui and co, (MITSY) with a PE of 8. Mitsui is a Japanese trader in the industrial sector. Low PE ratio, well run, recently bought by Warren Buffett.

Here is my international portfolio break down:

Canadian: 30%
Foreign: 26%
USA: 44%

Marc’s Monthly Moves

Sell Honeywell (HON).
Buy Mitsui and Co, (Mitsy)

Marc’s Portfolio YTD Performance

Portfolio return: 10.5 % (including currency losses)
Portfolio return: 11.0% (without currency losses)
S&P 500 return: 12.5%
RSP ETF S&P equal weight: 1%
TSX: 2.0%

The portfolio has under performed the S&P 500 by 1.5% percentage points. It has over-performed the Canadian market by 9.5%, which is a big vote for international diversification.